Legal Aspects of Finance Slide Set 5 Investment

Legal Aspects of Finance Slide Set 5 Investment Firms - Legal Standards on Customer Relations - Other Regulation of Investments Firms Matti Rudanko

Legal Basis DIRECTIVE 2014/65/EU OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU REGULATION (EU) No 600/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 15 May 2014 on markets in financial instruments and amending Regulation (EU) COMMISSION DIRECTIVE 2003/125/EC of 22 December 2003 • implementing Directive 2003/6/EC of the European Parliament and of the Council as regards the fair presentation of investment recommendations and the disclosure of conflicts of interest (Commission Investment Recommendations Directive) No 648/2012 Legal Aspects of Finance 5 2

Legal Basis, cont. Act on Investment Services (14. 12. 2012 / 747) • Repeals: Act on Investment Service Companies (2007) FSA Standard 5. 5: Investment recommendations and accepted market practices FSA Standard No 1. 3: Reliable Administration and Arrangement of Activities FSA Standard 2. 4: Customer identification and customer due diligence. Prevention of money laundering, terrorism financing and market abuse FSA Standard No 2. 1: Standard on code of conduct for the provision of financial services. FSA Standard No 2. 3: Standard on financial services agreements Legal Aspects of Finance 5 3

Investment Firms 1 Banks Finance and credit card companies Investment companies Special credit institutions • Invest in shares or real estate. • Municipality Finance, Finnvera, Finnish Export Credit • owned by the public sector • carry risks that a private financier does not want to assume. Legal Aspects of Finance 5 4

Investment Firms 2 Mutual funds • Mutual Funds Act and the EU UCITS (Undertakings for Collective Investment in Transferable Securities) directive Insurance institutions • manage securities transactions based on their customers’ orders to buy or sell Securities • In October 2004 there were 47 investment service businesses in Finland brokers Legal Aspects of Finance 5 5

Financial Organizations Federation of Finnish Financial Services • Merger of The Finnish Bankers’ Association, Federation of Finnish Insurance Companies and The Finnish Finance Houses Association The Finnish Venture Capital Association. The Advisory Office for Bank Customers The Finnish Association of Mutual Funds The Finnish Securities Complaint Board The Finnish Association of Securities Dealers Legal Aspects of Finance 5 6

Customer Relations Act on Investment Services (AIS) Ch. 10 A securities intermediary shall conclude a contract on the provision of investment services in writing. The liability to conclude a contract in writing shall, however, not apply to a securities intermediary when he provides investment services to a professional investor. (Sect. 3) AIS Ch. 1 Sect 18, Ch. 10 Sect. 1: professional / non-professional investors, eligible counterparties (Ch. 1 Sect. 19, Ch. 10 Sect. 11) • Investor compensation fund: only non-professional investors • Classification of clients and agreements on it; information to be given to the client on the status as an investor • Register by the FSA on professional investors • Eligible counterparties: exceptions from certain intermediary duties In a contract relating to the provision of investment services, a securities intermediary may not employ a term that is contrary to proper practice or otherwise unconscionable for the client. Legal Aspects of Finance 5 7

Mi. FID main reforms and amendments Know your customer and give information Classification of customers • Taking care of investor needs and rational decisions • Prevention of criminal acitivities • Professional / non-professional clients • Eligible counterparties Classification of investment firms / their • business Classification of marketplaces E. g. systematic internalizers • Regulated markets / MTF’s / OTC’s Legal Aspects of Finance 5 8

Regulated markets Regulated market means a multilateral system • operated and/or managed by a market operator, • which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments • in accordance with its non-discretionary rules • in a way that results in a contract, • in respect of the financial instruments admitted to trading under its rules and/or systems, • and which is authorised and functions regularly and in accordance with Title III of this Directive Legal Aspects of Finance 5 9

Multilateral trading facility (MTF) Multilateral trading facility or ‘MTF’: • a multilateral system • operated by an investment firm or a market operator, • which brings together multiple third-party buying and selling interests in financial instruments • in accordance with non-discretionary rules • in a way that results in a contract in accordance with Title II of this Directive Legal Aspects of Finance 5 10

Organised trading facility (OTF) Organised trading facility’ or ‘OTF’ • a multilateral system • which is not a regulated market or an MTF • in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact • in a way that results in a contract in accordance with Title II of this Directive Legal Aspects of Finance 5 11

Direct electronic access to a trading venue An investment firm that provides direct electronic access to a trading venue shall have in place effective systems and controls which ensure • a proper assessment and review of the suitability of clients using the service, • that clients using the service are prevented from exceeding appropriate pre-set trading and credit thresholds, • that trading by clients using the service is properly monitored and that appropriate risk controls prevent trading that may create risks to the investment firm itself or that could create or contribute to a disorderly market Legal Aspects of Finance 5 12

Conflicts of interests Investment firms shall take all appropriate steps to identify and to prevent or manage conflicts of interest • between themselves, including their managers, employees and tied agents, or any person directly or indirectly linked to them by control and their clients • or between one client and another that arise in the course of providing any investment and ancillary services, or combinations thereof, • including those caused by the receipt of inducements from third parties or by the investment firm’s own remuneration and other incentive structures. Where organisational or administrative arrangements are not sufficient the investment firm shall clearly disclose to the client • the general nature and/or sources of conflicts of interest and the steps taken to mitigate those risks before undertaking business on its behalf. Legal Aspects of Finance 5 13

Best Execution Obligation to execute orders on terms most favourable to the client (Best Execution rule) • Investment firms shall take all sufficient steps to obtain, when executing orders, the best possible result for their clients • taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. • Nevertheless, where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction. Legal Aspects of Finance 5 14

Eligible Counterparties An Eligible Counterparty (ECP) is an entity that is authorised or regulated to operate in the financial markets that is not given investment advice and belongs to one of the following categories: If such clients are provided with investment advice, they will be treated as Professional Clients instead. ECPs receive the lowest level of protection under Mi. FID. • Investment firms, Credit institutions, Insurance companies • UCITS and their management companies • National governments and their corresponding offices, including public bodies that deal with public debt • Central banks and supranational institutions Legal Aspects of Finance 5 15

Customer Relations, cont. “Know your customer” (AIS Ch 12 sect. 3) • the financial resources and experience • Information on services suitable for the client • Prevention of money laundering and funding of terrorism A securities intermediary shall aim at avoiding situations involving conflict of interests and, upon their occurrence, treat the client in accordance with proper practice. A securities intermediary shall treat his clients equally. A securities intermediary shall execute his orders carefully and in the best interest of the client without undue delay. Legal Aspects of Finance 5 16

Systematic internalisers Investment firm which, on an • Advance announcement to the FSA organised, • They shall publish a firm quote in frequent and those shares admitted to trading on a systematic basis, regulated market for which they are systematic internalisers and for which deals on own there is a liquid market. account by executing client • In the case of shares for which there is not a liquid market, they shall disclose orders outside a quotes to their clients on request. regulated market or an MTF Legal Aspects of Finance 5 17

Systematic internalisers 2 Systematic internalisers shall execute the orders they receive from clients in relation to the shares for which they are systematic internalisers at the quoted price at the time of reception of the order. Systematic internalisers may refuse to enter into or discontinue business relationships with investors on the basis of commercial considerations such as the investor credit status, the counterparty risk and the final settlement of the transaction. Systematic internalisers shall be allowed to decide, on the basis of their commercial policy and in an objective nondiscriminatory way, the investors to whom they give access to their quotes. To that end there shall be clear standards for governing access to their quotes. Legal Aspects of Finance 5 18

Post‑trade disclosure by investment firms Investment firms which, either on own account or on behalf of clients, conclude transactions in shares admitted to trading on a regulated market outside a regulated market or MTF, shall make public the volume and price of those transactions and the time at which they were concluded. Declaration of suspicious transactions to the FSA (SMA Ch. 14 Sect. 5) • Transactions suspected to include insider trading or market manipulation Legal Aspects of Finance 5 19

Investment services Purchase, sale, transfer and subscription of investment targets in one’s own name on behalf of another; brokerage on or execution of orders for investment targets (securities brokerage) submission of binding bids and offers in investment targets, their publication and notification to investors and trading in them on one’s own account (securities dealing) submission and publication of binding bids and offers in investment targets continuously or on request under a contract concluded with a marketplace or an issuer; public trade in one’s own name based on such contracts (market making) Legal Aspects of Finance 5 20

Investment services, cont. management of investment targets under a client-byclient contract in which decisionmaking power has been granted to the contractor (asset management) Investment advice Issue of subscription commitments in connection with the issue of a security or the conclusion of a derivatives contract (emission guarantee) acquisition of subscribers for investment targets or arrangement of their subscriptions (emission arrangement) Legal Aspects of Finance 5 21

Corporate Finance Arranging long term financing • services relating to issues of securities: • Emission arrangements / guarantees • venture capital • mezzanine instruments: preferred stock, subordinated loans, options, convertible bonds • company restructuring • syndicated loans • securitization Legal Aspects of Finance 5 22

Basics about Finance Forms of finance differ in four respects: Right to control Equity, Debt capital, Mezzanine (e. g. capital loan, preferred stock) • Owners: yes – preferred stock, capital loan and other creditors: no Mandatory yield • Equity and capital loan: No - debt capital: Yes Determination of yield • Debt and capital loan: fixed - equity: variable Position in the order of payment in liquidation • 1) creditors – 2) capital loan creditors – 3) owners Legal Aspects of Finance 23

Mezzanine and restructuring Mezzanine Restructuring • subordinated loans • options, option loans • convertible bonds • preferred stock • mergers • diffusions • share / asset deals, takeovers • LBO, MBO Legal Aspects of Finance 5 24

Securitization http: //www. investopedia. com/terms/s/securitization. asp An issuer creates a financial instrument by combining other financial assets and marketing different tiers of the repackaged instruments to investors. The process promotes liquidity in the marketplace E. g. mortgage-backed securities: • combining mortgages into one large pool • dividing the large pool into smaller pieces based on each individual mortgage's inherent risk of default • smaller investors can purchase shares in a larger asset pool (portions of a mortgage) as a type of bond. Without the securitization of mortgages, retail investors may not be able to afford to buy into a large pool of mortgages. Legal Aspects of Finance 5 25

LBO (Figure from Wikipedia) Legal Aspects of Finance 5 26

LBO, cont. A leveraged buyout (LBO) is when a company or single asset (e. g. , a real estate property) is purchased with a combination of equity and significant amounts of borrowed money, structured in such a way that the target's cash flows or assets are used as the collateral (or "leverage") to secure and repay the money borrowed to purchase the targetcompany/asset. Since the debt (be it senior or mezzanine) has a lower cost of capital (until bankruptcy risk reaches a level threatening to the lender[s]) than the equity, the returns on the equity increase as the amount of borrowed money does until the perfect capital structure is reached. As a result, the debt effectively serves as a lever to increase returns-oninvestment. (Wikipedia) Legal Aspects of Finance 5 27

MBO A transaction where a company’s management team purchases the assets and operations of the business they manage. A management buyout (MBO) is appealing to professional managers because of the greater potential rewards from being owners of the business rather than employees. MBOs are favored exit strategies for large corporations who wish to pursue the sale of divisions that are not part of their core business, or by private businesses where the owners wish to retire. The financing required for an MBO is often quite substantial, and is usually a combination of debt and equity that is derived from the buyers, financiers and sometimes the seller. (Investopedia) Legal Aspects of Finance 5 28

Investment banking; venture capital Investment banking Venture capital investors • manage share issues, acquisitions, mergers, and general accounting and financial consultation. • Cf. Commercial banking: • deposit and credit business • transfer of payments • fixed-term, equity-based investment in SMEs not listed on the stock exchange but with good growth potential. • convertible bonds, bonds with warrants and mezzanine financing • at the end of the term, the venture capitalist’s investment is realised: selling his or her shares to other company owners / acquiring new owners / listing the company on the stock exchange. Legal Aspects of Finance 5 29

Emission arrangement Issuer No contractual relations investors Emission arranger (if authority from the issuer) Legal Aspects of Finance 5 30

Liability norms relating to the roles Authorized agent of the subscriber (contractor) • norms on commission contract (agency) (KK Ch. 18) Emission guarantor • liability norms on the contractual relationship Emission arranger • norms on disclosure duties on securities markets • contract law norms on commission contract Legal Aspects of Finance 5 31

Syndicated loans / emissions • Managing underwriter – concludes the contract with the issuer as an agent of the group • divided syndicate contract – responsibilities of the members • selling group – marketing Legal Aspects of Finance 5 32

Contracts SYNDICATE • Emission arrangement / syndicate • the arranger is responsible for following the official norms • contents of contracts – mutual liabilities – indemnity: exemption of the agent from e. g. disclosure liability Legal Aspects of Finance 5 33